Healthy margins are a telling signal of a healthy business. But what’s considered a good net profit margin can vary depending on the industry, and depending on the year.
In my mind, it’s difficult to understand what constitutes a good net profit margin (also called “net margin”, or “net income margin”) when you have no context.
So in this post, I’ll do three things:
- Explain the basics of net profit margins
- Show the average net profit margin for the S&P 500 over the last 25 years
- My favorite part: Reveal a shocking truth about net margins
There are all sorts of profitability margins which describe pretty well how a company is controlling its costs and making a profit. My colleague Dave Ahern already wrote an excellent post on the 3 main margin ratios, which can be summarized as the following:
- Gross margin
- Operating margin
- Net margin
If you are a beginner, I highly recommend going through that article first. As someone with more experience with financial statements and accounting, I’d like to offer a quick shortcut that really helps me understand each of the ratios, and recall them.
Each of these margin ratios can be calculated using a company’s income statement.
First, let’s separate the main expenses that every company has to face as a part of doing business.
- COGs (cost of goods) = What it takes to create a product or service
- SG&A (selling, general, & administration) = marketing and corporate
- R&D (research and development) = your engineers and research team
- Interest, taxes, depreciation, amortization = the “ITDA” in EBITDA
Now that we have those definitions, let’s group them into the 3 main profitability/ margins ratios:
Top-line = sales
Operating margin (also EBITDA)
Net profit margin (Net Income)
= the bottom line
Hopefully that was easy enough, I recommend doing what I did. Put a sticky note of that breakdown next to your computer and soon enough you’ll have it memorized.
So now that we know what constitutes the net margin, we’ve just uncovered the pros and cons of using it, and even the three profitability ratios in general.
- Shows you where (or when) a company needs to do a better job at cutting costs (low comparable margins)
- Shows you companies that are excellently managed and efficient (high net margin)
- Gives you a good estimate of how much in sales a company will need to make how much profit
- Will fluctuate as Net Income fluctuates. Especially pronounced if there’s a large tax benefit or charge
- Can be misused if an investor doesn’t compare the ratio to the correct context (apples to apples)
Alright, now that we know what a net profit margin is, and how it is sourced from an income statement, let’s decide what constitutes a good net profit margin.
Like all smart analyses, this requires data.
The Average Net Profit Margin of the S&P 500 over the Last 25 Years
Since I have access to excellent datasets, and love to dive into this stuff, I’ll provide two of them:
- For the entire S&P 500
- By industry (of the S&P)
Here’s a table using the current 500 S&P 500 constituents, with their historical net profit margins from 2001- 2020:
I included the MEDIAN of the industries to find the S&P 500 average per year since a few industries had averages into the extremes, which distorts the true average.
Over this entire time period, the average net profit margin of the medians by year was 8.9%.
So, we can surmise that a good net profit margin is anything 10% or above, and really is dependent on the year and economy as much as the individual companies.
For example, you can see that the S&P 500 had good net profit margins during the 2014- 2020 period, with below average net profit margins in 2009-2010.
Now there is some survivorship bias in this data as it doesn’t update with each S&P 500 change over the years, and so you have some companies which were in a growth phase during the first decade and became more profitable in the second decade. And you had some companies with great net profit margins (like some of the FANGs) which were included in the S&P 500 in later years.
But overall, the dataset provides a good representation of how profit margins have looked across the S&P 500 historically, and gives us good context on what separates a good net profit margin from a subpar one.
How Small Improvements in Margins Can Lead to HUGE Growth in EPS and FCF
In breaking down the ramifications of margins, I guess like an engineer would tear down a device, I had an epiphany about just how powerful small improvements in margins can be.
It really was best illustrated for me by using a hypothetical example on a spreadsheet.
Let’s assume for the purposes of this example that a company has a 10% net profit margin, which we’ve established is pretty reasonable across the universe of stocks. Our company might have the following statistics then:
- Sales = $500
- Gross = $200
- EBITDA = $100
- Net Income = $50
So, what would an improvement of 1% in margins do to our financials?
Honestly, a 1% improvement didn’t seem like a lot to me at first, maybe that’s intuitive. After all, 1% of $500 is just $5, which is a pittance to this company, right?
Well actually, if the company was able to save 1% in costs at any point of that margin picture, and it flowed all the way down to the bottom line and they now have $5 more in profits, that means…
Our Net Income just jumped 10%, or from $50 to $55, just from a 1% increase in margins!
It gets better. Say we had a 3% improvement in margins, or just $15 of cost savings. Our Net Income would increase from $50 to $65, which represents a 30% increase.
And it becomes even more significant as you examine lower margin businesses! Let’s use an example of a company with an 8% net profit margin. Similar example here:
- Sales = $500
- Gross = $175
- EBITDA = $75
- Net Income = $40
The same 1% improvement in margins, $5, would turn $40 in Net Income into $45, which represents an instant 12.5% increase in Net Income!
It’s all because of the numbers, and how the percentages work!
How to Think About Cost Savings and Margins
The thing about these margin improvements too is that most cost savings plans should flow directly down to a company’s bottom line, at least in general.
For example, a savings in Cost of Goods from a margin perspective would flow most of the way through.
If a laptop manufacturer was able to find a cheaper source of electronics components which saved on costs with every laptop unit produced, that would be an example of COGs savings which is a margin improvement.
Since it’s on every item produced/sold, that 1% improvement increases Gross Margin by 1% without the company having to increase any other employment related costs like SG&A or R&D. So that 1% increase in Gross Margin becomes a similar 1% increase in Operating Margin, which flows down to Net Income (and Net Profit Margin) except for the small increase in taxes from the extra profits.
But we need to make sure that we’re not confusing nominal cost savings with percentage based, margin savings.
For example, lower COGs because less items were produced because of less demand may decrease costs, but that would mean that revenues were also decreased by a similar amount, which keeps the gross margin the same even though costs have decreased.
You can use the same logic of improving gross margins to increase net profit margin for improvements in operating margins too, if a company has operating leverage—meaning they can increase revenues without having to increase operating costs (like employment related to SG&A and R&D) in a proportional amount.
That’s where the real magic in margins lies, when a company has high operating leverage and can expand those gross or operating margins by increasing revenues while keeping operating costs suppressed.
An example of a company with a high operating leverage would be a company like Hershey’s or Netflix, who has pricing power and can increase revenues by raising prices while keeping costs the same.
Companies might not want to admit publicly when they have these advantages as it can irate customers, but high operating leverage often comes from competitive advantages, which allow for pricing power or other features of the business that allow for margin expansion.
Example: Margin Improvement and Long Term Growth
It’s that margin expansion where I want to focus on next, because not only does it have a potential multiplicative effect in the short term, it can also contribute significantly to long term growth—which is extremely relevant in growth estimates for valuation.
Let’s go back to a simple example to illustrate just how powerful that can be.
Take Hershey’s again, $HSY.
If I pull up the long term financial data of the company, you can make calculations which show that over the last 10Y, revenue grew by 4.2% CAGR while EPS grew by 11.1% CAGR.
How can a company grow profits faster than revenues to this extent?
The answer lies in the company’s ability to increase its net profit margin.
Since stock buybacks also helped contribute to the company’s 11.1% CAGR in EPS, we’ll use a comparison between Net Income and Revenue to ignore the effects of shares outstanding for a moment. In the same 10 year time period, Net Income was increased by 10.2% CAGR compared to that 4.2% CAGR of revenue.
Let’s calculate the net profit margin for 2009, which is the initial date for our 10Y period.
Revenue = $5,299 million
Net Income = $436 million
Net profit margin = Net Income/ Revenue = 8.2%
Now we’ll make the same calculation for the ending period, or fiscal year 2019.
Revenue = $7,986 million
Net Income = $1,250 million
Net profit margin = Net Income/ Revenue = 14.4%
You can see that in this same 10Y time period, Hershey’s was able to improve their net profit margin by 6.2%, and herein lies the secret to a company growing profits faster than revenues.
In fact, outside of using buybacks to reduce shares outstanding, it is the only possible way to grow earnings faster than revenues.
With this example, we can make a very interesting observation.
Notice how a 6.2% improvement in net margin led to a 6% higher growth in Net Income than the 4.2% growth in revenue (10.2% 10Y CAGR in Net Income – 4.2% 10Y CAGR in Revenue = 6%, similar to the improvement in net profit margin we just calculated, 6.2%).
That’s a significant contribution long term CAGR growth over 10 years, from those 6% of percentage points of net margins improvement.
That means that for valuation models, we can bake margin improvements into our growth estimates, and if a company at any point improves its net margin by a certain amount, the company will see a superior long term EPS and Net Income growth to the extent that the margins are improved).
Suddenly, those comments about cost savings of $20 million for a $1.5B company perk up my ears a lot more, as even small percentages of sales mean significant long term growth of earnings.
Limitations, Analyses, and Takeaways
The limitations of using net profit margin improvements in valuation are inherent in the problems with the net profit margin ratio itself.
Since net margin can fluctuate so wildly from year to year, I actually like to use operating margin as a better long term proxy of a company’s margins.
And this might seem counterintuitive, but I prefer a company with lower operating margin today but a history of higher operating margin in the past.
What this signals to me is a company with a great future growth catalyst, achievable simply by reaching profitability and efficiency levels that it was previously able to achieve. As long as the profitability of the industry itself has not changed much, or the company’s competitive advantage has not eroded, it’s generally safe to bake a few points of margin improvements into a valuation.
As we know, even a couple of percentage points added to a growth estimate can make a big difference in a company’s intrinsic value, which can uncover additional value opportunities among companies.
You always want to incorporate a margin of safety into valuations, and be conservative with growth estimates and margin improvements.
But if a company has had a good net profit margin in the past, and seems like it can grow back into those margins in the future, I think it’s a fantastic signal and a great way to evaluate the long term growth potential of future cash flows.